Looking Backward

September 15, 2008

Rest assured. The Obama campaign is on the issue of the financial crisis.They campaign sent out a memo to reporters to
this effect:

Senator Obama did a call this morning with some of
his key economic advisors including Paul Volcker, Bob Rubin, Lawrence Summers
and Laura Tyson about the state of the financial markets. They discussed
what to expect from financial markets today and over the course of this week,
how these events would impact the overall economy, and what steps should be
taken to address the problems in our financial markets and economy more broadly.

The only person missing from this list of advisors is Alan
Greenspan.I don’t want to generalize
about these advisors, but I think that Democrats, and the Obama campaign, would
be wise to make a distinction in their mind between neo-liberal and liberal
economics.The ‘90s were the heyday of
neo-liberal economics, which attempted some accomodation with the conservative
laissez-faire variety. And part of that accomodation consisted in opposing new
government regulations of the financial industry and attempting to remove old ones
like Glass-Steagall. Under Bob Rubin, the Clinton Treasury Department took the
lead.

Anyone who wants to be reminded of this history should look
up the story of Brooksley
Born, the former chair of the Commodity Futures Trading Commission under Clinton. In Jaunary 1999, Born decided not to seek
second term because of opposition from Rubin to her attempt to regulate
derivatives – the kind of unregulated financial instrument that even then was
undermining the stability of the financial system.

Here is an excerpt from an interview with Born where she
described her experience trying to regulate over-the-counter trading
instruments during the second term of the Clinton
administration:

Weren’t derivatives also responsible for the
collapse of a large hedge fund?
Yes. During the time that I was at the commission, Long-Term Capital Management
had to be bailed out by a number of the large OTC derivatives dealers because
it had $1.25 trillion worth of derivative contracts at the same time it had
less than $4 billion in capital to support them.

I became enormously concerned about OTC derivatives and thought
the market was a nightmare waiting to happen. About three months before we knew
about Long-Term Capital Management, the commission came out with a concept
release in the Federal Register asking for input from
the industry and other interested people concerning the need for more oversight
of the over-the-counter derivatives market. I was particularly concerned that
there was no transparency. No federal regulator knew what kind of position
firms like Long-Term Capital Management and Enron had in the derivatives
markets. These instruments can be used to reduce economic risk, and they are
certainly very valuable and useful economic instruments, but they can also
create enormous risks, as they did at Enron and Long-Term Capital Management.
Warren Buffett has recently called them financial weapons of mass destruction.

Nominally and statutorily, OTC derivatives were under the CFTC’s jurisdiction,
and the CFTC had exercised its discretion to partly exempt the market, but kept
some powers and responsibilities that it had no ability or possibility of
exercising or enforcing. Although I was willing to be persuaded otherwise, I
felt strongly that while heavy regulation was not required, transparency was
needed, and some federal regulator should have information before a disaster occurred rather than only
afterwards.

How was the concept release received?
There was a firestorm of criticism from the large OTC derivatives dealers, and
they were supported by other financial regulators.

What was the ultimate outcome of the regulatory effort?
It wasn’t a regulatory effort. We were just asking questions! The concept
release didn’t propose any rules. Alan Greenspan, Arthur Levitt, and Robert
Rubin all said that these questions should not be asked and urged Congress to
pass a bill that would forbid the commission from taking any regulatory steps
on over-the-counter derivatives. There were no hearings on that bill, but
during a congressional conference committee meeting on an appropriations bill,
an amendment was added preventing the commission from taking any action on
over-the-counter derivatives for six months. This occurred within a month after
Long-Term Capital Management’s collapse!

I
thought it was very bad policy, but on the other hand it was Congress’s
decision to make, and having made that decision Congress relieved the
commission of its responsibility, so that Enron, for example, became the
Congress’s responsibility, not the commission’s.

What is the relevance of all this?First of all, derivatives are part of the
same problem as subprime mortgages – they are part of what Paul
Krugman calls the “shadow banking system.” Ignoring them, and letting the market rule,
was part of the neo-liberalism of the ‘90s.. Secondly, and more to the point, Wall Street
is now worried about derivatives.Writes The Washington Post today, “What worries regulators and Wall Street is a
massive, multitrillion-dollar lattice of interlocking financial instruments
known as derivatives.”

Perhaps, those neo-liberals like Rubin who opposed regulation in the '90s have changed their mind. Certainly, some of them have. But just to be safe, Obama might consider looking for advice to some of the people who were critical of Rubin et al.
during these years, people who thought that more rather than less regulation
was needed.